The investment industry made a massive blunder when it made beating the market its mission, Charles Ellis, founder of a United States-based financial markets consulting company and author of Winning the Loser’s Game, told a recent conference in Cape Town.
He says investing based on the premise that you can out-perform the market is a loser’s game like gambling, politics and war. The reason is the massive competition between asset managers, Ellis told the IMN African Cup of Investment Management Conference held in Cape Town recently.
Ellis is the founder of Greenwich Associates and a director of Vanguard, the first company to develop index-tracking funds.
Fifty years ago, 90 percent of trading on the New York Stock Exchange (NYSE) was conducted by individuals advised by a trusted adviser who read little, Ellis says.
Today, 90 percent of trading is conducted by institutions that employ outstanding, hard-working individuals who read widely and have access to an incredible amount of information, he says.
Trades on the NYSE have risen from 1.5 million a day 50 years ago to more than five billion a day.
Institutions are the market, and they cannot as a group out-perform themselves, Ellis says. Due to the cost of active management and the impact of large transactions, most investment managers will under-perform the overall market.
Out-performance is harder and harder to find, Ellis says.
“Disagreeable data” are abundantly available, he says. Research in the US shows that 60 percent of mutual fund (unit trust) managers under-perform the market in a typical year, Ellis says. Over 10-year periods, 70 percent of managers under-perform, he says, and over 20 years, the figure is 80 percent.
Research also shows that the losers lose twice as much as the good fund managers out-perform their benchmarks, and, Ellis says, these statistics are “pretty grim odds”.
The secret to winning is to lose less than others lose, he says.
In addition, asset management fees have risen and are beginning to exceed the out-performance that active managers generate, he says.
Investment managers often say their fees are “only” one percent or half-a-percent of the assets invested, but you should compare this cost with what you are paying for, Ellis says. You already own the assets and so what you are paying for is the return on those assets. A fee of one percent for a return of seven percent means the fee is close to 15 percent of the return, Ellis says.
Sooner or later, investors will realise that they can invest in a passive investment for lower fees and still receive returns similar to those active managers deliver, he says.
It is time the investment industry stopped emphasising “mission impossible” and focused on something it can do better: being of service to investors, Ellis says.
Investors make the loser’s game worse because they get excited and pile in when actively managed funds perform well, he says. They then typically experience poorer returns and sell out after a fund has had a bad return, before its cycle turns back to good returns. This behaviour results in investors eliminating about one-third of the returns that funds earn, Ellis says.
The real opportunity of the investment industry is to teach investors how to have control over their money and to play “the contrary game” (buying when markets are low and selling when they are high), he says.
LOCALS LAG IN TAKING ADVANTAGE OF LOWER-COST PASSIVE INVESTMENTS
Passive investments are under-utilised by both retirement funds and individual investors in South Africa despite the immediate benefits investors can derive from the lower costs of their investments, an investment conference heard recently.
David McCarthy, a retirement policy specialist in the tax and financial sector policy division of National Treasury, told the IMN African Cup of Investment Management Conference that Treasury is puzzled as to why passive investing appears to be so unpopular.
Passively managed investments track an index, or an index adjusted for certain fundamentals, or shares that conform to a particular style.
McCarthy says before selecting an active manager, retirement fund trustees need to check very carefully that they have chosen an appropriate performance benchmark, that all the factors beyond the manager’s control are purged from any performance evaluation, and that performance data are not skewed by survivor bias (that is, managers or funds that have closed or merged are not included in performance tables).
An actively managed investment should be used only if it passes all the tests, otherwise a passive investment may be the better bet, McCarthy says.
Helena Conradie, head of Smartcore at Sanlam Investment Management (SIM), says a simple but powerful way to enhance returns is for investors to replace some of their actively managed equity investments in a balanced portfolio with lower-cost passive investments.
She cited an example of a balanced portfolio with 70 percent in equities, 15 percent in bonds, 10 percent in cash and five percent in property. The 70-percent equity allocation was replaced with 50 percent in passively managed investments – this was partly invested in the FTSE/JSE Equally Weighted Top 40 index and partly in the FTSE/JSE Dividend Plus index.
The balance of the equity allocation (20 percent of the fund) was given to an active manager.
The returns on the original balanced portfolio to May this year were compared with those of the portfolio with 50 percent in passive investments. The results were a significant reduction in costs, from 1.3 percent a year to 0.89 percent a year, Conradie says. This enhanced performance by close to three percentage points over three and five years, she says.
McCarthy did, however, point out that the passive investments available to retail investors have a wide variety of fee structures and levels.
He also said the costs of exchange traded funds may be understated because the costs of brokerage or of investing through a platform are excluded.